Four-week rally in US crude rekindles ‘flash crash’ fears

The risk of a disorderly decline in benchmark U.S. crude futures is growing after a four-week rally sent prices to 16-month highs and money managers amassed record bullish bets, defying an economic slowdown in China and the North American shale energy supply boom.

WTI (West Texas Intermediate, the oil grade underpinning the U.S. crude futures benchmark) last Friday flipped to a slight premium over its Brent counterpart for the first time in three years, reflecting stronger refiner demand, U.S. economic optimism and efforts to drain the supply glut at the WTI oil storage hub of Cushing, Oklahoma. Brent's premium over its U.S. rival stood $1.26 a barrel at around 11.00 a.m. Singapore time on Wednesday.

Although bullish momentum may continue to favor U.S. crude, WTI appears over-priced at current levels near $110 a barrel and a well-overdue reversal should bring the market closer in line with fundamentals, according to traders, strategists and analysts contacted by CNBC. Any softness in scheduled U.S. or China economic data releases this week may be the catalyst for the pullback, they added.

"We do not think that WTI's new-found supremacy can be sustained beyond a limited period of time," Credit Suisse analysts led by Jan Stuart, Head of Energy Research, wrote in a report on July 23. Though underlying supply and demand factors in the U.S. interior "make sense," the shape of the WTI forward curve is "abnormally steep" reflecting expectations of tighter supply, the bank noted.

"We would sell that structure, a little beyond the spot months, beginning with the first signs of fading of those near-term supply/demand fundamentals' strength."

Credit Suisse added: "We suspect that another six to eight weeks of summer strength represent more upside than downside risk, mostly for Brent."

Any softness in scheduled U.S. or China economic data releases this week may be the catalyst for the pullback.

Activity in China's manufacturing sector slowed to an 11-month low in July as new orders faltered and the job market darkened, Reuters reported citing a preliminary survey on Wednesday, suggesting the world's second-largest economy is still losing momentum. The flash HSBC/Markit Purchasing Managers' Index fell to 47.7 this month from June's final reading of 48.2, marking a third straight month below the watershed 50 line which demarcates expansion of activities from contraction.

Brent crude and its U.S. counterpart were marginally weaker at $108.24 and $107 respectively at 11.00 a.m. Singapore time.

"Any commodity that has a fundamental value shift can correct quite dramatically," said Thomas McMahon, director and CEO of Pan Asia Clearing Enterprise and the former CEO of the Singapore Mercantile Exchange.

Exactly half of those polled in CNBC's weekly sentiment survey (15 out of 30) believe a correction is coming this week, more than a third (11 out of 30) remain bullish while four respondents are 'neutral'.

Should a correction take place, some in the market fear high-frequency computer trading programs may trigger a disorderly price decline over a relatively short duration of time: a so-called 'flash crash'.

Apply that scenario to the oil market and a "quick and precipitous fall in prices, say $10 a barrel in one day...is entirely possible," said Warren Gilman, Chairman and CEO of investment firm CEF Holdings. "Volatility in all markets seems to have increased in recent years becoming almost the norm when direction changes occur."

Others are less pessimistic, ruling out an outright price collapse. "A 'flash crash' is an unlikely outcome but a slide is on the cards as WTI is massively overbought," Eugen Weinberg, head of commodity research and senior commodity analyst at Commerzbank told CNBC on Friday.

The sheer weight of top-heavy positioning makes the market particularly vulnerable to a sharp downleg should investors chose to liquidate those holdings – a possible scenario if downbeat economic data break or if the dollar strengthens.

"Speculators and investors have helped drive WTI quotes up meaningfully," Credit Suisse analysts noted in their July 23 research report. Investor open interest (or the number of contracts that have yet to be closed, liquidated or delivered) and net length have soared to 270,000 WTI-linked futures contracts, they said. "The main worry is that due to such a high net length, any sharp risk-off move could have a disproportionate effect on WTI markets."

Recent history is a guide. Speculators piled on long positions - or bets that prices will rise - pushing them to a record just before the oil market's last 'flash crash' on September 17, 2012 when Brent plunged more than $5 a barrel in a wave of late, high-volume selling that surprised even veteran traders.

Respondents in this week's survey targeted $109-$110 a barrel as a critical level where WTI oil bulls may capitulate.

"WTI has enjoyed the perfect storm on the upside: U.S. summer driving season, reports of declining U.S. inventories, all-time highs in equities and free money chasing return," said James Cordier, founder of Optionsellers.com in Tampa, Florida.

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"I feel WTI ends here at $109, however. Long term resistance here is enormous and likewise so will be supply in the U.S. in coming months. We expect to see WTI trading back below $100 in August," he said, adding that the decline will likely begin this week.

Like the U.S. Federal Reserve's policy path, oil too is not on a "preset course," said Phil Flynn, senior market analyst at the Price Futures Group in Chicago "but at some point soon we should see oil drop about 10 bucks. That will be data, weather and refinery dependent, of course."

Many continue to point out that current pricing is out of sync with fundamentals and a re-pricing of the market could bring it closer to more realistic market conditions.

"It's pretty obvious that there is no lack of supply…it becomes quite puzzling to see prices rise," said Oil & Energy Daily's Chief Investment Strategist, Karim Rahemtulla. "I know firsthand that there are tankers sitting around laden with oil as I have seen this in the Strait of Malacca a couple of months ago and in the Strait of Hormuz before that and also in Suez."

Plus, the shale-oil and gas boom is "real" and gaining momentum he said. "I was in Alaska two weeks ago meeting with the Energy Commissioner and they are pushing hard to get on-shore oil fracking up and running for this winter season off Prudhoe Bay. And, my contacts in the oil patch are seeing a pick-up in activity since Memorial Day and we should see rig counts increase in the Q3 and Q4 as a result, for the first time in years."

Rahemtulla added: "Could there be a 'flash crash'? Definitely. Prices have moved 10 percent in the past couple of weeks in the face of a strong dollar, weakening global fundamentals and no discernible increase in demand. But, the charts show that being bearish at this time is the wrong side of the trade."